Why Regulators Delayed the Volcker Rule

Federal regulators announced Thursday that final implementation of the Volcker Rule will be delayed two years beyond the nominal deadline this July. The delay is a win for banks that were struggling to adjust to the looming restriction on their ability to make money through market trading as opposed to the more traditional, less profitable, business of lending at interest.

But before you jump to the conclusion that this is all just a massive scam cooked up by the banks and their regulators to boost annual bonuses by gambling on Wall Street with Mom-and-Pop deposits there are a few facts to consider.

True, a simple idea has been rendered impossibly complex as it moved from the mouth of former Fed chief Paul Volcker’s through the brains of regulators at the Office of the Comptroller of the Currency (OCC) and into hundreds of pages of vaguely worded rules. Originally, you will remember, the idea was a return to the 1938 Glass-Steagall bright-line distinction between banks that make money through lending (commercial banking) and banks that make money through investing (investment banking).

But contrary to popular opinion, the Glass-Steagall Act was rescinded not because it maintained that bright-line distinction, but because it had completely failed to do so. While some traditional banks had stayed on the “commercial” side of the Glass-Steagall line, a shadow banking system based on money market deposits and equal to or greater than the traditional one had grown up outside the Glass-Steagall restrictions explicitly to avoid them. Ultimately it was this shadow banking system’s collapse, not the commercial banks failure, that caused the 2008 crisis. Only the government’s emergency and ad hoc extension of its guarantee of deposits over the money markets in the fall of 2008 prevented a global economic catastrophe.

The question the Volcker Rule ultimately has to answer is “Who gets to stay under that umbrella of government safety?” Put another way, “how much risk taking in service of market efficiency are American’s willing to backstop?”

This is ultimately a philosophical question, but the left-right spectrum is narrower than you might expect. To simply reinstate a Glass-Steagall prohibition on trading by commercial banks is unacceptable even to die-hard supporters of the Volcker Rule on the left. Barney Frank, Robert Johnson, and Joseph Stiglitz, for example, are all on the recordsaying [.pdf] that commercial banks must be allowed to trade on the market in order to perform their most important function: allowing the efficient movement of capital throughout the financial system.

Unfortunately, this “market making” role for banks is distinguishable from trading for profit (“proprietary trading”) only by the intention of the banker doing the trading, regulators and the authors of Dodd-Frank concluded. How to judge intentions that may exist only in the opaque minds of Wall Street traders? Unlike Wittgenstein, regulators do not believe that “whereof one cannot speak, thereof one must remain silent.” Coming up with workable language to regulate trader intention is one of the primary reasons for the delay in implementing the Volcker Rule.

But just because it’s hard doesn’t mean it can’t work: even the vague preliminary Dodd-Frank moves to regulate risky trading by banks are causing some to close their proprietary trading operations. What the two-years delay really buys is time for the newly-appointed head of the OCC, Thomas Curry, who comes from the consumer-friendly FDIC, to show whether he can do better than his predecessors at crafting regulation to limit risk taking by the big banks.